Professor predicts economic growth in 2005

By Mario Belotti

Most economic data we have seen from the end of 2004 indicate that the U.S. economy has entered a period of solid and sustainable economic growth. In 2004, the U.S. economy grew at a real rate just above 4 percent. This year, I expect the economy to expand at a real rate of 3.6 to 3.8 percent, a rate just above the economy’s long run potential.

As was the case in 2004, a large part of the expected growth will come from an increase in consumer spending. U.S. households today are in a good position to continue to increase their spending. For one thing, in 2004, the economy created 2.2 million new jobs. In 2005, U.S. firms are expected to add another 2 million jobs, possibly more. New jobs lead to higher household income and higher spending.

Consumer spending this year will also continue to benefit from rising wages and salaries, from low inflation, from low but somewhat rising interest rates, from stable or lower energy prices, from a thriving economy, and from a further increase in household net worth—the value of all assets minus liabilities.

In 2004, because of increases in the prices of homes and of financial assets, household net worth (wealth) is estimated by the Federal Reserve to have increased by more than $4 trillion to a total of $47 trillion, a new historic high. U.S. household net worth is expected to increase again this year, even though by a smaller amount. Economic studies show that 3 percent to 4 percent of such increases are spent on consumption. It is true that U.S. consumers in the last few years have substantially increased their debt. At the same time, however, the value of their assets has increased by a much greater amount. Moreover, because of increases in household income, the percentage of household after-tax income necessary to service their debt today is lower than two years ago and not much higher than 10 years ago.

Consumers started the year feeling reasonably comfortable about the economy, especially because of the growing availability of jobs. The various consumer confidence indexes that have shown some weaknesses in the 2004 summer months rebounded strongly in December. Such increases in consumer confidence generally translate into future increases in consumer spending.

Because of all the above, I expect consumer spending to increase this year by 3 percent to 3.5 percent, thus contributing as much as 2.3 percentage points to the growth of the economy.

In 2005, businesses are also in a very good position to increase their spending and to hire more workers. In the last few years, U.S. business firms have restructured their production activities, have eliminated most of their unprofitable divisions and, with the help of low interest rates, have improved their balance sheets. As a result, in the last two years, they have seen large increases in cash flow and profits. In 2004, for example, the firms that make up the S&P 500 index saw their profits increase by almost 20 percent. They saw, according to a Smith Barney study, their net debt to capitalization fall to 33 percent, the lowest in 10 years. They saw their ratio of capital spending to cash flow reach a new historic low. Moreover, these same companies by the end of 2004 held $600 billion in cash.

In 2005, business firms will also continue to benefit from low interest rates, from higher stock prices, from higher exports, and from an expanding economy. The U.S. manufacturing sector has been improving since March 2003 and, according to the Supply Management Institute, major manufacturing firms expect this sector to continue to expand in 2005. The same Institute reported much the same for the much larger service sector. The mining and agriculture sectors have just completed their best year in the last several years, both because of greater production but also because of higher prices for their products. Both of these industries will continue to expand this year and increase their purchases of new machinery and equipment. The residential construction industry, the one mostly affected by rising interest rate, will show a relatively small decline in 2005. Such decline however, will be made up by projected increases in commercial and industrial construction.

Recent business surveys also point to increases in business investment in 2005. The December 2004 Business Roundtable Outlook’s survey of the largest corporations in the U.S. found that 50 percent of the CEOs expect their companies to increase capital spending in 2005 this compared to 35 percent in the September survey. Another survey by the Piper Jaffray Investment Bank in the fourth quarter of 2004 found that corporate plans for IT spending were at the highest level in the last eight quarters.

Because of all the above, I feel comfortable in projecting an increase in business spending for capital equipment and software of about 12 percent and of a total business spending in 2005 of 8 percent to 10 percent. Such increase will add another 1.3 to 1.5 percentage points to the year’s economic growth.

Increases in government spending will add less than half a percentage point to U.S. economic growth. The federal government wants to reduce the budget deficit and most state and local government revenues are not increasing fast enough to allow them to spend at a much higher level than the increase in inflation. I expect overall government spending this year to increase by not more than 2.3 percent after inflation.

Last year’s sharp decline in the value of the U.S. dollar against some of the world’s major currencies should bring some improvement to our balance of trade this year. However, given the poor economic performance projected for some of our major trading partners and given China’s reluctance to revalue its currency, I do not expect major improvements in our foreign sector and, therefore, there will be little or no contribution from this sector to 2005’s gross domestic product: at most, an increase of only 0.1 or 0.2 percent.

Inflation in 2005 will continue on a relatively mild path. The Chinese economy, whose voracious demand for raw materials in 2004 pushed most commodity prices strongly upward, is slowing down. Japan is growing very slowly and many European countries are growing slowly or not growing at all. Much manufacturing capacity around the world remains unused. Domestic and international competition in tradeable goods remains strong and central banks around the world are not about to let inflation get out of hand. Except for energy prices, even the substantial decline in the value of the dollar has not generated much inflation in the U.S. Given these circumstances, and given the fact that our productivity is still increasing, I expect inflation in the U.S. to increase this year by no more than 2.5 percent—an increase that should not make the FED unhappy.

Interest rates will increase but not enough to cause any changes in the economic scenario I have described. The FED will continue to raise short term rates this year as the economy continues to grow and employment increases. It will increase rates even if inflation is not much of a threat because it wants to bring the federal funds rate to a more neutral level: a level that does not affect the economy one way or the other. I expect that by the end of 2005, the federal funds rate will reach 3 percent to 3.25 percent. Long-term rates, including mortgage rates, are going to increase by about 50 to 75 basis points from where they are now. I do not expect higher increases in long term rates because U.S. firms, as pointed out earlier, can finance most of their capital spending needs with their own funds; housing construction and mortgage financing will demand less funds, the federal and state government deficits are falling, banks have ample liquidity and, given the performance of our economy and our increasing interest rates, I do not expect foreign investors to reduce by much, or at all, their investment in the U.S.

Changes to this forecast could occur if petroleum prices increased by another 20 percent to 25 percent, if the value of the dollar fell precipitously by a similar amount, and if the geopolitical situation turned strongly against the U.S. I do not expect any of these shocks to occur.

Mario Belotti is the W.M. Keck Foundation Professor in SCU’s Department of Economics. This forecast was originally presented in January 2005.